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May 14 (Bloomberg) — Romano Prodi recalls how he persuaded Germany to allow debt-swamped Italy into the euro: support our membership and we’ll buy your milk, he said.

When Prodi toured Germany’s agricultural heartland after becoming Italian leader in 1996, he pitched “a big milk pipeline from Bavaria,” pointing to a three-year, 40 percent plunge in the Italian lira that was hurting dairy sales. “To have Italy outside the euro, a huge quantity of exports from Germany would have been endangered,” Prodi, now 70, said.

Germany got the message, allowing entry rules to be bent to create a 16-nation market for its exporters. Now, German taxpayers are footing the bill for that permissiveness as Europe bails out divergent economies lashed to a single currency with little control over national taxes and spending.

The consequences are an 860 billion-euro ($1 trillion) bill for a debt binge led by Greece, sagging confidence in the European Central Bank’s independence and mounting speculation that a currency designed to last forever might break apart.

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

German-led northern Europe, with its zeal for budget discipline, is attempting to fix the mistakes made by the euro’s founding fathers in the 1990s. It is squaring off against the governments of the south over who will control the euro and the ECB; whether the currency will be used to promote growth or squelch inflation, and ultimately, whether some countries should be disbarred from the monetary union.

European Club

What was conceived as a club for Europe’s strongest economies was expanded for political reasons, leaving the currency union with minimal powers to police deficit spending and no safety net for dealing with countries, like Greece, that veer toward default.

“There was no discussion of that at all, of a crisis mechanism,” said Niels Thygesen, a retired Copenhagen University economics professor who served on the 1989 group led by European Commission President Jacques Delors that mapped out the path to the euro. “It was believed that if countries adhered more or less to prudent budgetary policies, that would not or could not happen.”

Kohl’s Role

Former German Chancellor Helmut Kohl, seeing the euro as the capstone of Europe’s economic integration and Germany’s return to the European family after two world wars, opened the door to the deficit-prone southern European countries that the Bundesbank, haunted by the memory of hyper-inflation, wanted to keep out.

Returning from the December 1991 summit in Maastricht, the Netherlands, that kicked off the euro project, Kohl told the German parliament that he wanted “the greatest possible number of countries” in the euro. That gave Italy, Spain and Portugal the encouragement to meet the economic targets to join in 1999 and Greece to follow two years later.

Defenders of the German economic model knew the threat posed by countries such as Italy, whose budget deficit was 10.2 percent of gross domestic product in 1991, when they forced European leaders to set 3 percent as the limit for euro members.

“A well-known German financial leader told me: Fortunately for Germany, Austria is between Italy and Germany,” said Alfons Verplaetse, who oversaw the Belgian central bank from 1989 to 1999. The reckoning was that only Germany and its immediate neighbors would pass the economic tests, limiting the euro to a handful of countries, Verplaetse, 80, said.

Nobel Laureate

Today’s euro is far from what economists like Nobel laureate Robert Mundell call an “optimum currency area.” Gross domestic product per person ranges from 69,300 euros in Luxembourg to 18,100 euros in Slovakia, debt from 14.5 percent of GDP in Luxembourg to 115.8 percent in Italy, and unemployment from 4.1 percent in the Netherlands to 19.1 percent in Spain.

“A currency without a state is difficult to manage,” said former Italian Prime Minister Lamberto Dini, 79, who also served as the nation’s finance and foreign minister. “The decision to create a single currency in Europe was an eminently political decision. It was supposed to bring about greater European integration not only at an economic level, but at a political one.”

Europe’s multi-state structure leaves it without a U.S.- style federal tax and financial-transfer system to smooth discrepancies between richer and poorer regions. The EU’s budget, mostly for farm aid and infrastructure projects, represents barely 1 percent of the bloc’s GDP, compared with European national budgets that average 47 percent of GDP.

The Blueprint

Signs of a mismatch between strong and weak economies and a loose coordination of fiscal policies were noticeable in the earliest blueprint for a common currency.

“In view of the marked divergences that persist between member states in realizing the goal of growth and stability, there is a risk of surging disequilibriums unless economic policy can be harmonized,” Luxembourg Prime Minister Pierre Werner wrote in the 1970 report that introduced Europe’s first bid for a single money.

Four decades later, Werner’s prophecies are coming true, as euro-region governments prioritize domestic needs to pacify voters after the deepest recession in a half century. The EU Commission estimated May 5 that the overall economy will grow 0.9 percent in 2010, not enough to create jobs, after shrinking 4.1 percent in 2009. It predicts unemployment will climb to 10.3 percent in 2010 from 9.4 percent in 2009.

Euro Rejection?

German officials are already debating what was unthinkable to the euro’s architects: that a currency union designed in its founding treaty to be “irrevocable” might not be. Finance Minister Wolfgang Schaeuble said March 12 that expulsion from the euro may be the ultimate penalty for serial violators of debt rules.

Under current EU law, ejection is “legally next to impossible,” the ECB said in December. Changing the treaty requires unanimity among the EU’s 27 governments, so the euro’s current lineup — likely to be joined by Estonia next year — will have to find a way of making do.

Markets have rendered a mixed verdict on the euro’s resistance to the crisis. The currency’s decline below $1.25 from a record high of $1.60 in July 2008 still leaves it above the 1999 starting rate of $1.17. The euro is about 11 percent overvalued against the dollar, data compiled by Bloomberg of purchasing power parities show.

Maastricht Treaty

Greece’s ability to get into the euro illustrates what is wrong with Europe’s uncoordinated economic management. Greece, the EU’s poorest country at the time of Maastricht, set about cutting its budget deficit from 16.3 percent and persuading the Germans that it was serious about being fiscally prudent.

By 1996, with Greece’s deficit at 7.4 percent of GDP, Finance Minister Yannos Papantoniou was confident enough of making the grade that he pleaded for the euro’s paper money to feature the name “euro” in the Greek alphabet.

The German reaction wasn’t encouraging. Theo Waigel, Germany’s finance minister at the time, responded by saying he had “enough trouble in Germany trying to sell this idea of giving up the mark, and now you want me to put funny letters on it as well,” said Ruairi Quinn, then Irish finance minister, recalling the altercation at an April 1996 meeting in Verona, Italy. Waigel added that “it’s all irrelevant because you’re never going to qualify,” according to Quinn.

Greek Letters

The global economic boom of the late 1990s enabled Greece to meet the targets for deficits, debt, inflation, interest rates and currency stability. Greece joined the monetary union in 2001 and a year later, banknotes featuring generic architectural symbols and embossed with Greek lettering went into Europe-wide circulation.

Waigel started with a “very negative position,” said Papantoniou, 60, the Greek finance minister from 1994 to 2001. He responded to the German’s outburst in Verona by offering him “an appointment in two years’ time to check this out and you’ll change your mind.”

“Once we entered the euro, we forgot about the necessity of carrying on this structural effort and we now pay the price,” Papantoniou said. Waigel, now 71 and a lawyer at GSK Stockmann + Kollegen in Munich, wasn’t available to comment for this article.

What Societe Generale SA economist Dylan Grice dubs a “Greek tragedy” dates to 2004, when the new Conservative government of Costas Karamanlis accused its predecessor of fiddling the budget numbers to pass the euro test — a charge Papantoniou denies. EU records now show that Greece has never brought its deficit under the limit.

‘Greek Drachma’

“Investors had always regarded the euro as a de jure German mark,” Louis Bacon, founder of the $15 billion hedge- fund firm Moore Capital Management LLC, wrote in an April 16 letter to investors who have made an annual return of 20.5 percent from his flagship fund during the past two decades. “It’s dawning on the world that it is becoming, de facto, a Greek drachma.”

Greece’s credit rating was cut to junk by Standard & Poor’s on April 27, making it the first euro member to lose its investment grade.

The nation’s slipping competitiveness was masked by an economic expansion buoyed by the euro-driven drop in bond yields to 3.23 percent in September 2005. Growth peaked at 5.9 percent in 2003, topping the euro zone that year. Unit labor costs that bounded ahead by as much as 10.2 percent in 2002 put Greece at a disadvantage to countries like Germany, where wages declined in 2004, 2005 and 2006.

‘New Odyssey’

Greece’s fiscal crisis was exposed after another change in government, from the conservatives back to the socialists last October. Prime Minister George Papandreou, elected on a promise of higher wages and benefits, is now on what he calls a “new Odyssey” that may end with the dismantling of the welfare state built by his father Andreas, Greek leader from 1981 to 1989 and 1993 to 1996.

Italy’s journey to the euro followed a similar script to Greece, from German opposition to reluctance to acceptance. Then the paths diverged. Italy kept its deficit under the limit five times in the euro’s first 11 years. Deficit-obsessed Germany has only done so six times.

Led by Prodi, Italy snuck under the deficit ceiling in 1997, the test year for the first group of euro aspirants, helped by a one-off “Eurotax” and a yen-denominated swap. Italy wasn’t alone in coming up with one-time savings and accounting dodges. France transferred pension funds from France Telecom SA to graze the 3 percent limit.

Bundesbank Bid

Even Waigel made an ill-fated bid to get the Bundesbank to boost the paper value of its currency reserves to reduce Germany’s debt.

Germany’s tight-money faction dictated the rules for the euro, yet it lost out when Waigel’s call for automatic sanctions on countries with deficit overruns was rejected by other governments in talks that culminated in Dublin in December 1996.

Prodi, who served two stints as Italian leader and ran the EU Commission from 1999 to 2004, said the “crisis isn’t unexpected. It came much later than I thought.”

The euro project is “half baked,” he said in an April 20 telephone interview. “You cannot have a monetary policy without coordination in fiscal and economic policy, because otherwise you will have problems.”

The budgetary lapses cloud EU efforts to quell Greece’s crisis and prevent a stampede by speculators against Portugal as well. Germany, for example, is again pressing for curbs on deficits as long as its own economy escapes closer oversight.

‘Fractious Mobilization’

Bickering over Greece, exacerbated by Germany overruling French opposition to making the International Monetary Fund part of a rescue, contributed to the euro’s slide this year against the dollar. Moody’s Investors Service cited the “fractious mobilization” of EU support as a reason why it cut Greece’s credit rating on April 22.

Spain, France and Germany have scoffed at a May 12 EU Commission proposal for more coordination of taxing and spending plans before they are voted on by national parliaments. The commission also urged more “expeditious” enforcement of the deficit rules, without calling for tougher fines on violators.

“The old idea that you discuss with peers your budgetary plans before they’re announced is very difficult to implement,” said Jean Pisani-Ferry, a Maastricht-era EU economic adviser who now runs the Bruegel research institute in Brussels. “It runs up against the politics.”

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